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HCP: Some Troubling Findings?

Seeking value in a health care real estate investment trust

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Mark Yu
Jun 27, 2016
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Conservative investors must probably be buckling up for a soon, already started, bumpy ride in the market.

The BREXIT event had nothing to help in terms of stabilizing the cash market. The event did not fail to wreak havoc across global market indices on Friday. Further, the event pushed most market movers (hedge funds and money managers) to place their bets on precious metals. Reuters indicated that this is the most net long positions in both gold and silver since records became available (2006). On the same day, the volatility index (VIX) rose 50%, highest since 2011, indicating presence of market turbulence (uncertainty).

This speculation of possible recession in the United Kingdom, magnified market turmoil, renewed political tension, among others, should not dictate that an investor "sell first and ask questions later." In a Bloomberg interview,

Howard Marks (Trades, Portfolio), Oaktree Capital co-chairman, does not believe that the event is not a financial catastrophe.

“That (sell first and ask question later) does not sound like a very clever or stable position. There is an old saying, ‘The markets abhor uncertainty ...’ When uncertainty rises, they do sell, but that does not make them right.

“It’s (selling) always a matter of what you are selling at what price.” – 

Howard Marks  (Trades, Portfolio) (on BREXIT)

Interestingly enough, for true perennial index investors out there who check or adjust their portfolio quarterly or every six months may find no significant changes in their holdings. Standard & Poor's 500’s market performance year to date (June 24) was nearly flat at -0.32%. That performance included the 10.51% drop in January and the 3.58% drop Friday. Nonetheless, that is not saying that the S&P 500 would not drop further.

On Friday, global financial cash markets from east to west showed a common reaction to the BREXIT event. Only a few countries – namely, Finland, Sweden, Venezuela, Egypt, and Israel – exhibited an upward movement. In the U.S., only the Utilities sector (6% of S&P 500) and precious metals (Gold and Silver) showed a bit of a positive return at 0.09% and 3.62%. REITs were probably the second least affected among several indices, which performed -1.10% as a group.


A REIT, or Real Estate Investment Trust, is a company that owns or finances income-producing real estate. Modeled after mutual funds, REITs provide investors of all types regular income streams, diversification and long-term capital appreciation. REITs typically pay out all of their taxable income as dividends to shareholders. In turn, shareholders pay the income taxes on those dividends. REITs allow anyone to invest in portfolios of large-scale properties the same way they invest in other industries – through the purchase of stock.

According to the National Association of Real Estate Investment Trusts (NAREIT), REITs comprise several sectors. A REIT can be specialized in either of the following: office, industrial, retail, residential, diversified, health care, lodging/resorts, self-storage, timber, infrastructure, data centers, specialty and mortgage.

FTSE NAREIT US Real Estate Index

The FTSE NAREIT US Real Estate Index is designed to measure the performances of all publicly tradable, nonconvertible, perpetual preferred stocks.

According to NAREIT performance data, the FTSE REIT index returned an annual average of 11.89% since 1971, while the S&P 500 returned 10.26% all including dividend reinvestments. Specifically, the Self-Storage sector outperformed other sub-REIT sectors at 19.22% annual average return in the same time frame. Self-storage REITs were followed by Health Care, Residential and Retail with 14.24%, 14.13%, and 14.08%.

HCP Inc.

HCP Inc. (

HCP, Financial), an S&P 500 company, invests primarily in real estate serving the health care industry in the U.S. The company’s share price returned 0.41% on the day when even blue chips fell. This may be a pronounced myopia on the company, as other REITs also were in the green on that day, such as Ventas (VTR, Financial) (+1.26%), Omega Healthcare Investors (OHI, Financial) (+0.46%) and Realty Income Corp. (O, Financial) (+1.94%).

But HCP warrants further checking since it has several laurels itself: the company has been a publicly traded company since 1985, has 31-plus years industry experience, was the first health care REIT selected to the S&P 500 index and was the first REIT included in the S&P 500 Dividend Aristocrats index. Further, the company has provided 14.9% compound annual total shareholder return since 1985.

As of Friday, HCP was trading at 1.73 times its book value compared to the S&P 500’s 2.75. In contrast, HCP has a trailing 12-month (ttm) profits of (negative) -$203 million, thus giving it variably poor values on other traditional metrics, such as price to earnings: n/a, return on equity: -2.09% and profit margin: -22%.

This was the only first time in the past decade that HCP encountered a loss in profits. To add insult to injury, most financial advisers downgraded the company as an investment option, year to date. Barclays and Morgan Stanley downgraded the company to "Underweight/Underperform" while Goldman Sachs already put the company as a "Sell" in September last year.

Reviewing HCP’s recent annual filing that was made in February this year gave some interesting insights in how the company was operating.


(p. 44, HCP’s annual report)

*FAD are funds available for distribution (FAD) value represents a measurement of a REIT's cash flow for shareholders and investors (Investopedia).

An observer would probably have questions in his mind as to why the company, despite showing a negative $560 million in profits, was able to end up with funds available for distribution (FAD) of $1.26 billion.


Fear not as HCP explained a couple of paragraphs later, that the massive reduction in profits from 2014 to 2015 was because of a $1.3 billion impairment charge from HCRMC DFL investments among others.

HCRMC direct financing lease ("DFL") investments

HCRMC stands for HCR ManorCare. HCRMC contributes 23% to HCP’s total sales. In April 2015, HCRMC received a Department of Justice (DOJ) complaint followed by the lawsuits filed by former employees of HCRMC under the qui tam provisions of the federal False Claims Act (Bloomberg). Parts of the civil actions alleging that they submitted claims to Medicare for therapy services that were not covered by the skilled nursing facility benefit, were not medically reasonable and necessary, were not skilled in nature and therefore not entitled to Medicare reimbursement.

In September 2015, Judge Claude M. Hilton denied HCRMC’s Motion to Dismiss the Medicare fraud complaint. The case will now transition into discovery, where the government will seek to develop additional information supporting their fraud allegations.

This discouraging prognosis led HCP to reduce its investment value in HCRMC, thus the HCRMC DFL investments, by $1.3 billion in its 2015 annual report. In addition, HCP has this following bold statement on p. 13 regarding HCRMC:


The $1.3 billion impairment charge can be broken down into two parts: $817 million impairment was secondary to reduction in real estate property value and $478 million impairment was based on the present value of future lease payments that HCP was supposedly entitled to receive prior to the HCRMC Lease Amendment that became effective as of April 2015.

Why FAD is still positive?

Going back, HCP had negative $560 million in profits, was able to end up with funds available for distribution (FAD) of $1.26 billion. This $1.8 billion difference is quite huge, given that in 2013 and 2014, FAD to profits difference were in $200 million on average.

As HCP described FAD in p. 43:

"FAD is defined as FFO as adjusted after excluding the impact of the following: (i) amortization of acquired market lease intangibles, net; (ii) amortization of deferred compensation expense; (iii) amortization of deferred financing costs, net; (iv) straight-line rents; (v) accretion and depreciation related to DFLs and lease incentive amortization (reduction of straight-line rents); and (vi) deferred revenues, excluding amounts amortized into rental income that are associated with tenant funded improvements owned/recognized by us and up-front cash payments made by tenants to reduce their contractual rents …

"… Other REITs or real estate companies may use different methodologies for calculating FAD, and accordingly our FAD may not be comparable to those reported by other REITs. Although our FAD computation may not be comparable to that of other REITs, management believes FAD provides a meaningful supplemental measure of our performance and is frequently used by analysts, investors and other interested parties in the evaluation of our performance as a REIT. FAD does not represent cash generated from operating activities determined in accordance with GAAP, is not necessarily indicative of cash available to fund cash needs and should not be considered as an alternative to net income (loss) determined in accordance with GAAP."

Some worrying signs there indeed.

Nonetheless, HCP will try to get rid of this suffering business, which is further mired by a DOJ investigation through a spinoff. The company announced in May this year that its HCRMC portfolio (including skilled nursing and assisted living assets, as well as other skilled nursing facilities) will be spun off into an independent publicly traded REIT.

United Kingdom investments

HCP’s operations can also be affected in the recent BREXIT event. According to Value Line, the company increased its investments most notably in the U.K. by $278 million. HCP has some $879 million investments in the U.K. This represents an estimated value of 3.94% of HCP’s total investments made in 2015.

Balance and cash flow sheet

According to HCP’s recent quarterly filing in March, the company had a debt-to-equity ratio of 1.18. The company also had $75 million in free cash flow, according to GuruFocus.


(HCP, Inc. Company Overview)

In summary

There is no question that HCP has been an exemplary health care REIT ever since it became a company. Given its stellar dividend growth in the past decades, HCP deserves a closer look for dividend yet conservative investors out there.

Disclosure: I do not have shares in HCP Inc.

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